The impact of unconventional monetary policy on perceptions of tail risk

Masazumi Hattori, Andreas Schrimpf, Vladyslav Sushko17 November 2013

This column argues that asset purchases and forward guidance by central banks can be effective in reducing financial market participants’ tail-risk perceptions. US data suggest that, since their inception in 2008, the unconventional policies adopted by the Federal Reserve have significantly compressed perceptions of tail risk. Despite increases in risk premia during the recent ‘tapering’ episode, estimates of tail-risk perceptions still remain significantly below the levels observed when the measures were introduced. Still, the effects of exit on tail-risk perceptions remain uncertain, and will require careful monitoring.

A common, but hitherto unproven, notion is that central banks have effectively curbed perceptions of tail risks in financial markets by means of their unconventional policies.1 Such an effect is distinct from the well-documented compression of long-term yields (see Woodford 2012 for a comprehensive discussion). A reduction in tail risk perceptions will have an immediate effect on the pricing of risky assets, such as equities, and may have provided extra support for risk-taking behaviour – which was one of the aims of unconventional policies.

In a recent working paper (Hattori et al. 2013), we present evidence that both announcements and actual asset purchases by the US Federal Reserve substantially reduced market participants’ perceptions of tail risks embedded in option prices. The sustained impact of the Fed’s actual purchases on perceived tail risks, i.e. their flow effect, not just their announcement effect, is noteworthy – it suggests policy transmission via portfolio rebalancing effects (i.e. through the changing balance in Treasury securities held by the Fed and the private sector), even after any policy announcement had been incorporated into option prices. Thus, the impact of unconventional monetary policy on financial markets may have been broader than suggested by earlier empirical studies.

One way to assess how market participants perceive tail risks is to look at the costs of hedging strategies that aim to insure against a sharp fall in stock prices by establishing S&P 500 index option positions with very low exercise probabilities. The difference between the option premia for the puts and calls used in this sort of hedge (‘risk reversal’) effectively captures the asymmetry in the tails of the implied return distribution (Figure 1).2 As concerns about extreme downside risks increase, put options become more expensive than call options, thus pushing up the overall cost of the risk reversal.

We evaluate the effect of the Fed’s quantitative easing (QE) and forward guidance announcements on gauges of tail-risk perceptions using event study techniques.3 The results obtained from analysing 17 key Fed announcements from 2008 until 2012 suggest that perceived tail risks fell significantly during the days following the announcements (by around 10% over a 10-day window). The observed declines were immediate, with lower levels sustained for weeks afterwards (Figure 2a). In contrast, the response of the VIX (an indicator of implied overall volatility, often referred to as the ‘fear gauge’) was somewhat more sluggish, with significant changes detected only for longer event windows (Figure 2b). This suggests that the transmission of policy announcements to implied return volatility mostly originated from investors’ repricing of extreme downside risks (as captured via risk reversals), rather than their expectations for overall volatility per se (as incorporated by the VIX).

Figure 2a. Tail-risk guages before and after Fed announcements

Notes: Average readings of 10- and 25-delta risk reversals 22 days before and after the 17 announcement dates associated with the Fed’s unconventional monetary-policy measures.

Figure 2b. The VIX before and after Fed announcements

Notes: Average readings of the VIX 22 days before and after the 17 announcement dates associated with the Fed’s unconventional monetary policy measures.

Flow effect of Fed purchases and differences across policy phases

There is also evidence of a significant flow effect from asset purchases, which further contributed to a re-pricing of our option-based tail-risk gauges.4 The effect is identified after controlling for prevailing macroeconomic and financial conditions. For example, option prices are also affected by stock prices, which themselves tend to rise in response to central bank purchases. However, it is only the movements in equity index options orthogonal (i.e. unrelated) to any such changes in the underlying equity index itself that we attribute to changes in tail-risk perceptions.

The impact of purchases becomes especially discernible around the ongoing QE3/MEP phase, and was particularly strong for purchases at the long end of the yield curve – suggesting a significant impact from the Maturity Extension Program (MEP). Similarly, the announcement effects described earlier, when looked at by policy phase, indicate that the declines in tail-risk perceptions were particularly pronounced during the QE1 period and, again, during the Fed’s operations unveiled in 2012 for the ongoing QE3 phase. These results, indicating a time-varying impact, are in line with simulations by Chen et al. (2012), who conclude that forward guidance enhances the effects of asset purchase programmes.

The recent ‘tapering’ episode

The measured cost of hedging against downside risks via equity index options rose when market participants revised their expectations about the so-called ‘tapering’ of unconventional policies by the Fed. This followed positive labour market news releases and the Congressional testimony by Fed Chairman Ben Bernanke on 22 May (Figure 3a, dashed lines). The release of FOMC minutes on 19 June triggered yet another adjustment (Figure 3a, solid lines). However, this time, the effect on equity option-based tail-risk gauges was only temporary – in contrast to bond markets, where volatility expectations continued to be revised upwards in subsequent days (Figure 3b). In fact, the levels of risk reversals – approximately 9 vols (units of annualised volatility, in percent) for 10-delta risk reversals – remained below their 2008–2012 average (Figure 1) and, especially, below their levels prior to the policy announcements made during those years (i.e. between 20 and 25 vols for 10-delta risk reversals – see Figure 2a).

Notes: S&P 500 10-delta risk reversal ten business days before and after 22 May 2013 testimony to Congress by Fed Chairman Ben Bernanke and 19 June 2013 release of FOMC minutes.

Figure 3b. MOVE index before and after Bernanke’s testimony and release of FOMC minutes

Notes: MOVE Index 10 business days before and after 22 May 2013 testimony to Congress by Chairman Ben Bernanke and 19 June 2013 release of FOMC minutes.

These dynamics may suggest that market participants’ expectations about Fed ‘tapering’ shifted at a time when the tail risks themselves had receded sufficiently to allow for a relatively smooth exit. Following this interpretation, the impact of unconventional policies on risk reversals would tend to be asymmetric – larger in bad times than in good times – because central banks would tend to put QE measures in place when the economy is fragile, and remove them when the economy has recovered sufficiently. At the same time, relatively low current readings of risk reversals (compared to their average in recent years) also convey the possible magnitude of adjustment if market or macroeconomic developments lead to a resurgence of tail-risk concerns in the future. As a consequence, the effects of exit on tail-risk perceptions remain uncertain. The sensitivity of risk reversals to shifts in market expectations in response to policy announcements warrants careful monitoring in future.

Theoretical backdrop

How can these effects on risk perceptions be understood from an economic perspective? The significant flow effect from Fed purchases suggests that policy transmission to tail-risk perceptions may be taking place via the balance sheets of financial intermediaries. In terms of conventional monetary policy, Bernanke et al. (1999) and related papers have long emphasised the role of private-sector balance sheets in policy transmission. Subsequently, Borio and Zhu (2012) have specifically highlighted the transmission via financial intermediaries and risk spreads. The mechanics behind the impact of the latest, unconventional, measures are likely to be related. For example, Brunnermeier and Sannikov (2012) suggest a concept of ‘stealth recapitalisation’ of holders of long-term bonds, with central bank purchases effectively providing insurance against tail events, if accompanied by clear communication and a commitment to make policy actions conditional on future states of the economy. Policy transmission may also operate through the funding side of financial intermediaries (see Adrian and Shin 2010), whose risk-bearing capacity may be enhanced if there is a credible commitment to keep short-term rates low. The use of risk management technology such as Value-at-Risk could, in turn, change the valuation of downside risks across a range of assets, and is likely to show up in broad measures such as S&P 500 index options.

Disclaimer: The views expressed in this column are those of the authors and do not necessarily reflect those of the Bank for International Settlements.

1 See, for example, the column by IMF Chief Economist Olivier Blanchard in The Economist of 31 January 2009 and the speech by Federal Reserve Vice Chair Janet Yellen on 4 March 2013 at the National Association for Business Economics Policy Conference in Washington DC.

2 These tail risk gauges can be expressed as the difference between the implied volatility of a deep out-of-the-money put and the implied volatility of an out-of-the-money call option of the same moneyness (option price sensitivity to the underlying asset) and maturity. We chose to consider risk reversals based on 25-delta options (‘out of the money’) and 10-delta options (‘deep out of the money’) in view of their very low sensitivity to incremental movements in the S&P 500, which means that it would take an extreme swing in stock prices for such options to be exercised.

3 By QE, we refer to outright purchases of Treasuries and maturity extensions of the Fed’s balance sheet whereby long-term purchases are accompanied by sales at the short end. For convenience, we refer to the Fed’s large-scale asset purchase programme announced in December 2008 as QE1, the programme formally announced in November 2010 as QE2, the maturity extension of the Fed’s balance sheet that began in September 2011 as MEP, and the fixed-amount monthly purchases unveiled in September 2012 as QE3.

4 Baseline vector autoregression results indicate that the flow effect of Fed purchases on risk reversals persists for more than 12 weeks.